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Retirement plans
  • ERISA has certain requirements employee contribution plans must meet in order to be considered secured and protected.
  • Defined benefit plans (pension plans) and defined contribution plans (401(k)s, stock ownership, and profit-sharing plans) are qualified benefit plans under ERISA and the IRC.

Qualified plans

Qualified benefit plans offer tax-favored benefits to both employers and employees. To secure these favorable tax treatments, plans must comply with Title I of the Employee Retirement Income Security Act (ERISA) and applicable provisions of the Internal Revenue Code (IRC). Two varieties of qualified plans exist: defined benefit plans and defined contribution plans.

A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service; for example, one percent of average salary for the last five years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.

A defined contribution plan, on the other hand, does not promise a specific number of benefits at retirement. In these plans, the employee, the employer, or both contribute to the employee’s individual account under the plan, sometimes at a set rate, such as five percent of earnings annually. These contributions generally are invested on the employee’s behalf. Employees will ultimately receive the balance in their accounts, which are based on contributions plus or minus investment gains or losses. The amount in the account at distribution includes the contributions and investment gains or losses, minus any investment and administrative fees. Generally, the contributions and earnings are not taxed until distribution. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, employee stock ownership plans, and profit-sharing plans.

Other types of qualified plans include individual retirement accounts (IRAs), simplified employee pensions, 403(b) plans, Savings Incentive Match Plans for Employees (SIMPLE), and 457 plans. These are often used by the self-employed, employees of small companies, and tax-exempt organizations.

Traditional IRA

An ordinary individual retirement account (IRA), also called a traditional IRA, is any IRA that is not a Roth IRA or a Savings Incentive Match Plan for Employees (SIMPLE) IRA. An IRA, in general, allows a participant to deduct some or all of their contributions to the account. The contributions and earnings are not taxed until distributed. Even those who are covered by a retirement plan through their employer are able to contribute to a traditional IRA. However, all or part of the contributions may not be deductible if the plan participant or their spouse are covered by an employer-sponsored retirement plan.

In order to be eligible to contribute to an IRA, an individual must be under the age of 70½ and have taxable income such as wages, salaries, commissions, tips, bonuses, or self-employment.

Nonqualified plans

Some companies provide additional benefits to executives via nonqualified deferred compensation plans. These plans either allow participants to defer receipt of income or provide a supplemental retirement benefit beyond the limits placed on qualified plans. As such, the employee’s benefit is unsecured and not protected by ERISA or the Employee Benefit Security Administration.

Other issues

Minimum funding standards apply to certain retirement benefit plans. Other varieties of retirement benefit plans must be funded according to the terms of the governing plan document. An annual report (Form 5500) must be filed with the Internal Revenue Service (IRS) and made available for participants to inspect.

ERISA establishes certain minimum eligibility requirements for retirement benefit plans, mandating that employees cannot be excluded from participating provided they are at least 21 years old and have completed one year of service. ERISA also establishes minimum vesting requirements for retirement benefit plans.

Vesting is the process by which a retirement benefit becomes nonforfeitable; that is, when employees are permanently entitled to a portion of or all of their benefits derived from employer contributions. Two different types of vesting exist:

  • Cliff vesting is where benefits derived from employer contributions become 100 percent nonforfeitable after passage of a certain number of years.
  • Graded vesting is where the benefits derived from employer contributions become incrementally nonforfeitable over a set period of years.

403(b) Plans

A 403(b) plan, also known as a tax-sheltered annuity plan, is a retirement plan for certain employees of public schools, employees of certain tax-exempt organizations and certain ministers. A 403(b) plan allows employees to contribute some of their salary to the plan. The employer may also contribute to the plan for employees.

Saver’s Credit

The Internal Revenue Service (IRS) offers a special tax break called the Saver’s Credit that may be available to lower income taxpayers. By following certain guidelines outlined by the IRS, workers who contribute to a 401(k) plan, 403(b) plan, governmental 457 plan, and similar employer-sponsored retirement programs, may be eligible for this tax break.

Investment policy statement

An investment policy statement is simply a written plan to help guide the long-term investment goals for a company’s 401(k) plan. It is created to establish the guidelines for providing investment options in the plan. Participants rely on their employer’s “due diligence,” or thorough investigation, when a retirement plan vehicle is offered to help them prepare for their financial future.